Unlimited Liability as a Barrier to Entry

Abstract

Many but not all firms have the freedom to choose liability rules. In some countries, service professions have unlimited liability rules imposed by government; historically, banks in some countries faced unlimited liability. Why do governments impose unlimited liability? This is the question we address. With a simple model, we illustrate the agency conflicts in firms. Limited liability solves these conflicts efficiently. Unlimited liability raises the cost of capital; inefficiently small firms result. But under some conditions, selectively applied unlimited liability rules protect rents. We test several propositions with data on Scottish banking and U.S. law firms